income is the driving force that generates profit.
Commercial Real Estate Appraising 101
As a follow-up to my previous article, The 5 Keys to Unlocking the World of Commercial Real Estate Investing, I thought a good topic to discuss would be the basics of commercial real estate appraising. As I mentioned in my last article my experience in appraising, and the classroom education, as well as real world knowledge I've acquired through my MAI candidacy has allowed me to be a much more savvy investor.
The MAI designation is the highest designation in appraising, and it essentially allows a person to appraise anything, anywhere in the world. Needless to say my journey has enabled me to evaluate nearly every property type, as well as analyze how deals are structured regarding investment property. I have definitely seen the proper and improper ways to handle investments, and I have taken this knowledge and applied it to my everyday practice in investing, as well as appraising.
Knowledge of appraising is an integral part of investing in commercial real estate. After analyzing your personal financial situation, it is the next step to finding an investment that is right for you. If you don't understand appraising, then you may pay too much for a property, or buy a property that will not live up to your income requirements. It is highly unlikely that you'll be able to find a decent investment property without at least some minimal knowledge of appraising. Obviously, the more knowledge that you have, the more likely you are to find a really good investment. The reason being is appraising allows you to see the property from a different perspective, and like I've mentioned before, the numbers don't lie.
The first and most important factor to know about appraising investment properties is that income primarily controls value. Obviously, the more income a property can generate the higher the value should be. When appraising an investment property, usually the majority of the consideration is placed on the income approach.
The income approach is one of three approaches that appraisers utilize in their analysis. The other two approaches are the sales comparison and cost approach. The names of these approaches describe what takes place in the analysis.
The cost approach analyzes the property based on what the improvements would cost to construct minus accrued depreciation, plus the land value. This approach is rarely given any consideration when evaluating an investment property. The sales comparison approach analyzes the property based on the comparison of similar properties that have sold recently. This approach is given some consideration when evaluating commercial investment properties.
Finally, the income approach analyzes the property based on the income being generated, or income potential that the property may have. As mentioned earlier, the income approach is the most important when analyzing an investment property.
Since the income approach is the most important when evaluating investment properties, I will concentrate on providing you with the essential tools needed to properly analyze an investment property via the income approach.
When evaluating an investment property for a potential purchase, the first thing you need to do is analyze the historical income and expense figures. These figures should be provided to you by the current owner of the property you are pursuing.
I like to review at least three years of income and expense figures in order to get a good grasp on the historical performance of the property. I suggest that you set up an excel spreadsheet template that will allow you to plug in income and expense figures for properties you are evaluating. This way you won't have to reinvent the wheel every time you are looking at an investment. Once you've entered the total gross income, which is the total income generated by the property, you'll be able to start inputting the expense items. After the expense items are accounted for, you should deduct the total expenses from the gross income, which will results in a net operating income (NOI). The NOI is the most important figure when analyzing the income from an investment property.
Once you have established the NOI, you'll be able to apply a capitalization rate to it. I will elaborate on the capitalization rate shortly. After you've derived the NOI for the years prior, you'll need to look at the current rent roll (i.e. the current income being generated).
The current rent roll should be broken down to dollars per square foot, which is a common unit of comparison when evaluating income. Also another unit of comparison is dollars per unit, which is commonly utilized when analyzing apartments. By understanding what each tenant is paying on a dollar per square foot or a per unit basis, this will allow you to compare these rents to that found in the market for similar properties.
It is always smart to compare your property and rental rates to those in the market. The reason for this is if you are at above market rents, then you may have a higher likelihood that a tenant may not renew their lease, because there is cheaper, comparable space out in the marketplace.
On the flip side if the rents are below market, then you may be able to negotiate a rental increase when the leases roll over, which would result in a higher future value. Obviously this scenario is one that is most favorable to an investor, because you negotiate the sales price based on the below market rents, then hopefully negotiate the leases to slightly higher amounts, which then produce a higher value, and therefore additional equity in the investment.
You must be careful when negotiating the leases, because you don't want to get greedy and have the tenant move out on you. I typically like to negotiate the initial year of the new lease just below market, then have a step up to where the tenant is paying market rent by year two to three.
Capitalization rates are factors that are applied to the NOI (Net Operating Income)of a property in order to derive the overall value. The NOI of a property is divided by the cap rate, which then results in the value of the property.
For instance, if you have an NOI of $100,000, and a cap rate of 10%, then your value for the property is $1,000,000. Cap rates can also be applied to a value or asking price/purchase price in order to derive an NOI.
For instance, if you have a value/purchase price of $2,000,000 and typical cap rates for this type of property are 9%, then you would multiply $2,000,000 by 0.09, which results in an NOI of $180,000. The way in which you can derive cap rates from the market is you can take the NOI of a sale and divide it by the purchase price.
For instance, you have a property that has an NOI of $150,000, and it recently sold for $1,765,000, then the resulting cap rate would be 8.5%. Deriving cap rates from the market like this is the best way to understand rates for different property types in your area. There are also resources like RealtyRates.com and Korpacz that provide cap rates for various property types across the country. The only problem with resources like this is they are somewhat skewed by the larger markets. This is why it is best to get cap rates from sales in your market.
As a recap, the process of performing the income approach for a potential investment property should start with analyzing the historical income and expense figures. After you have calculated the NOI for the previous years, then you will need to analyze the current situation regarding income for the property.
This should be done by looking at the current rent roll or leases in place, and comparing them to rents and leases for similar properties in the area. Once you are comfortable with the current income situation, then you must look to the market for the proper capitalization rate to apply to the current NOI.
Capitalization rates are always applied to the annual NOI. The best source of a cap rate is from sales of similar income producing properties in the area. As mentioned earlier, there are publications that provide cap rates for various property types across the country.
Finally, once a cap rate is chosen for the property, then it is applied to the current NOI, which results in value conclusion for the property. The NOI is divided by the cap rate to get a value, the NOI is divided by the value or purchase price to get a cap rate, and the cap rate is multiplied by the value or purchase price to get the NOI. One factor can always be solved for if the other two factors are known.
This article has provided you with the basics for appraising an investment property. Obviously the most important thing to remember is that income controls the value of an investment property. The more income a property can generate the higher the value is going to be. Like I mentioned before, if you can analyze the income stream of a property using templates that you've set up, then you will be ahead of the game, and on your way to finding a profitable investment.***
Bryan Ehret: Commercial Appraiser, MAI Candidate, Real Estate
Developer/Agent, Investment Consultant, President of Construction &
Development Firm, Investment Coach/Mentor.
E-mail - bryan.ehret@gmail.com
Commercial Real Estate Expert/Analyst for The Real Estate Arena.
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